Muni Catchup 8/15

by Pat Luby

This Week in the Muni Catchup

3 Fewer Muni ETFs

Speaking of Muni ETFs…

Caveat Emptor

The Wisdom of Buffett

The Bottom Line

3 Fewer Muni ETFs

State Street Global Advisors announced that 12 ETFs will be closing soon, and that among them are 3 muni bond ETFs that are sub-advised by Nuveen. (BABS, CXA and INY.) While the three that are closing are the smallest of the SPDR muni ETFs, it does seem surprising given the $45+ billion in inflows into the municipal fund market this year, that these three funds have not been able to attract more attention from investors. In particular, BABS, which is focused on taxable Build America Bonds, a part of the muni market which I have viewed as presenting an overlooked opportunity for investors seeking taxable income. (There is a weekly update of flows into muni open-end mutual funds and ETFs on the Context page.)

Speaking of Muni ETFs…

For the first time in several years, munis will be on the agenda for this year’s Inside ETFs Inside Fixed Income Conference. There is a great line-up of speakers and ideas, so please consider joining me in Newport Beach in November. I will be presenting “The Case for Muni Bonds: Active vs. Passive in the Puerto Rico Era.”

Caveat Emptor or Audentes Fortuna Iuvat?

Bloomberg reports the approval of a plan to issue $800 million in munis to finish construction of what Governor Christie called “the ugliest damn building in New Jersey, and maybe America.”

The bonds will be non-rated and when they come to market will no doubt offer investors a much higher yield than investment grade bonds.

“Buyer Beware”? Some investors may reject the bonds offhand simply because of the garish appearance of the buildings (see for yourself) or a general distrust of non-rated bonds.

Or, does “Fortune Favor the Brave”? Other investors may be inclined to overlook some of the risks in order to pursue the promise of the higher yields.

Neither reaction is an appropriate way for the prudent investor to decide whether or not to buy. As Ben Graham wrote in The Intelligent Investor, “Operations for profit should be based not on optimism but on arithmetic.” (From Chapter 20, Margin of Safety.)

Self-directed investors who may be tempted to consider bonds such as these need to be honest with themselves about their ability to judge the merits and risks involved, and–even more importantly–their ability to maintain surveillance on the issuer’s ongoing financial condition. With rare exception, my preference would be that for investors for whom high yield is appropriate, consider using a professional manager to do so by investing with a high-yield open end mutual fund or one of the high-yield ETFs. Even for investors with a portfolio of individual bonds, adding a fund or an ETF to the portfolio is worth considering. (For additional reading, I recommend reading my article about The Benefits of Professional Managementand my two articles published by Van Eck about adding ETFs to a portfolio of munis. See the links on my Bibliography page.)

So after the bonds are issued for American Dream, fund and ETF owners may see them show up in their underlying portfolios, but they will be there because the portfolio manager made a rational decision based on arithmetic–not an emotional decision based on a need for income or an aversion to an ugly building.

Buyer beware? Yes–always. And does fortune favor the brave? Perhaps, but in my experience, fortune more often favors the prepared.

The Wisdom of Buffett

Is it hot where you are? It’s hot here..it has been hot, and the forecast is for more hot. In fact, right now it is hotter where I live than this well-known destination. Even though they have wide easy roads that have been recently repaved, I do not want to go there.

A better course of action may be to slow down and chill out with some “Wisdom from Buffett.” It is especially in summer when I find that his insights and stories really resonate with me, but his timeless wisdom transcends seasons and appeals to young and old alike. I have always been impressed by how well he is able to express himself, which is why–as my family knows–I simply refer to him as The Poet. This week’s quote:

The more we learn the less we know
What you keep is what you can’t let go
Take it fast or take it slow
Just one way for you to go
Don’t chu-know

From Don’t Chu Know, by Jimmy Buffett

THE BOTTOM LINE

Check Your Calls: Didn’t believe that rates could go down again, did you? Declining rates can mean an increase in market value but also an unwelcome increase in call risk. If you hold premium bonds (and who doesn’t!), beware of how concentrated your call risk is–especially before you add any additional callable bonds to your portfolio.

Beware the Coupon: All other things being equal, lower coupons mean higher duration and therefore higher interest rate sensitivity. Add in the unfavorable tax treatment of market discount on munis and investors who do not plan on holding bonds to maturity should be wary of buying par or discount bonds.

Curve Positioning: picking a spot on the curve is too much like trying to time rates–of which I am not a fan. Going out to the “bump” in the muni curve around 20-years can be tempting as there is not much incremental yield to incent investors to go further, and because of the slope of the curve, holding today’s 20-years bonds as they approach maturity may offer some nice price appreciation–if rates remain steady. But as shown on the Context page, 20-year par bonds can have a duration of close to 15–meaning that a 1% instantaneous increase in rates would mean a 15% decline in market value. That would hurt. So when you are looking at the curve positioning, check the duration. If you are considering funds, it can also be helpful to also check the correlation with your equity holdings. (See my recent article on ETF.com for additional insights on the topic.) Additions to your portfolio should reflect first and foremost what you need to get done with the money, not how you “feel” about the market.

If you are an advisor, please contact me if you need help deciphering any of this for yourself or your clients.